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The major development in yesterday’s European Central Bank policy meeting was a significant downgrade to the ECB’s staff projections for GDP growth and inflation in the euro area over the course of 2013.Since the ECB introduced it’s “Outright Monetary Transactions” (OMT) bond market intervention program in August, market volatility has been almost completely muted, and sovereign bond yields have fallen steadily throughout the course of the second half of the year. Concurrently, European stocks have been on a tear.
These two developments have put the euro crisis conversation squarely in the growth arena. The common line is that the ECB’s OMT pledge has sufficiently removed tail risks from financial markets for the foreseeable future. This, then, should allow policymakers to focus their full attention on measures aimed at reviving economic growth in the euro area.
Pursuant to this worldview, most strategists are calling for even higher stocks and even lower yields in the eurozone in 2013 as current trends continue and the currency bloc “muddles through” a mild recession.
In his 2013 outlook, titled In Authorities We (have to) Trust, Deutsche Bank credit strategist Jim Reid highlights a small problem with that narrative: the growth crisis and the market crisis are inextricably linked, and the ECB has actually done little to change that.
In fact, Reid argues that disappointing economic data – the one thing seemingly out of the ECB’s control – are what have driven the last two major selloffs in European markets:
The last two major European Sovereign risk off catalysts have been growth disappointments. In July 2011, the first sub-50 PMI print since 2009 for Italy started a 3-month savage sell-off that culminated in Berlusconi’s resignation, a technocrat Government and a couple of months later the first of two massive LTROs from the ECB. A period of calm and risk-on then ensued for 3-6 months as markets waited patiently (but expectantly) for a growth rebound after stability had been restored.
The growth rebound failed to materialise as we moved through Q2 2012 and the sell-off returned with a vengeance with Italian and Spanish equities hitting lows not seen for well over a decade in the former and for 9 years in the latter. 10 year bond yields in these two countries climbed above 6.5% and 7.5% respectively. The ECB finally rode to the rescue with the promise of the OMT program thus sparking the current large rally in peripheral risk and global markets generally.
So, what are the catalysts for a return of financial market turmoil in Europe in 2013?
Reid highlights three major issues.
To start, European stocks – and stocks in markets around the world, for that matter – are considerably overvalued based on historical correlations to PMI data:
[credit provider=”Deutsche Bank”]
In other words, markets may be considerably “overbought” at these prices, and they have a lot of room to move lower.
The second problem is austerity. Most accept that austerity measures weigh on economic growth in the short term, yet euro-area governments are moving forward with plans attempting to bring fiscal budgets back into balance anyway.
To make matters worse, the IMF recently concluded that the “fiscal multiplier,” or how much economic growth contracts for each dollar of spending cuts or tax hikes implemented by the government, is much higher than they previously estimated.
The IMF’s revelation helps to explain the third problem: namely, that governments have consistently set economic forecasts too high and then failed to meet their own targets.
The charts below provide a nice illustration of this dynamic. They show that governments have missed forecasts even issued as recently as 2011 (with the exception of Germany), and the further you go back through the years, the more off base those forecasts have turned out to be.
[credit provider=”Deutsche Bank”]
This unstable growth picture causes Reid to warn of “huge risk-off moments” materialising in Europe in 2013.
The reason: it brings concerns about solvency back to the fore, and Reid doesn’t see the ECB’s OMT program as any match for such fears arising in the market:
In 2012 the ECB prevented a financial meltdown by announcing its intention to buy short-dated bonds for countries in need via the OMT program. This is a huge step from the ECB but it remains a liquidity facility and not a solution to any solvency concerns that there may be in the future. For it to work successfully over the medium-term it needs to be proved that growth can stabilise in the most vulnerable countries and then show signs of picking up.
If we see some indication of this in 2013 then the European Sovereign crisis will continue to be on hold. However our fear is that if economists again under-estimate the negative growth consequences of this crisis and indeed austerity in the most vulnerable countries, then it’s possible we can have solvency concerns reasserting themselves even though a liquidity program is operational.
…the OMT program is a conditional liquidity scheme and if conditions are not met (for whatever reason) or there are doubts surrounding the solvency of any European country in 2013 due to weak growth, it is unlikely to be enough to prevent a sell-off in longer-dated periphery bonds and a general risk aversion that might require yet more extraordinary levels of intervention from the central bank to avoid the unthinkable.
Summing up the argument:
Spread valuations are still reasonable if defaults stay low as seems likely but expect a sell-off by mid-year if growth stalls as we expect. This will likely provoke the authorities and a buying opportunity will precede this. Such a pattern will likely repeat itself many times before this long crisis is truly over.
It’s difficult to assess where we’ll be in one of these mini-cycles by the time the calendar ticks over into 2014 but we think that these sharp market swings will dominate as the poor macro fundamentals continue to battle it out against extraordinary monetary intervention.
In short, Deutsche Bank thinks the crisis is far from over, and Europe is likely going to have a lot tougher time in 2013 than it did in 2012.